State corporate tax reform - things to consider

The February 25 Wall Street Journal included an article - "The State Business Tax Revolt Governors get a jump on corporate tax reform" noting that a few state governors, such as in Iowa and Florida, would like to reduce the state corporate income tax rate. The article contrasts this to President Obama's comment in his state of the union address to reduce the corporate tax rate although his FY 2012 revenue proposals do not include such a plan.

This all raises some questions such as, if states are having budget problems, why consider reducing a revenue source? The answer is economic development. Some lawmakers view a lower corporate tax rate as conducive to keeping and attracting business activity to the state. On the other hand, there are many, particularly individuals, who believe corporations have to pay their "fair share." These can be difficult positions to reconcile and the data is not clear as to what the right answer is.

Some considerations:

• Per 2009 US Census data, 9.4% of total tax revenues in California are from corporate income taxes (compared to 44% for the personal income tax and 29% for the sales tax). Similar data from the Federation of Tax Administrators shows that the average for the 50 states is that 5.6% of total revenues are from the corporate income tax.
• Ultimately, all taxes are paid by individuals. Taxes paid by businesses are ultimately paid by customers in the form of higher prices, employees in the form of lower wages or investors in the form of reduced earnings.
• An article from the Federal Reserve Bank of Kansas City - "Do State Corporate Income Taxes Reduce Wages?" by R. Alison Felix, noted that labor likely bears the greatest burden from the corporate income tax (page 83 - 84). The article notes that the corporate tax can cause corporations to seek the lowest tax rate. When a corporation leaves a state, there is less capital and workers become less productive and earn lower wages. The author notes that this can more adversely affect high-skill workers relative to low-skill workers because higher skilled workers may need access to high cost technology (capital).
• Businesses do use government services and the amount used can vary from industry to industry and the nature of the business. For example, a corporate sales office is unlikely to use as many government services as a shopping mall. But, is income the best measure of use of government services by businesses? Probably not.
• What exactly are corporate taxes? In addition to paying income taxes, they are also subject to sales tax, property taxes and a variety of other taxes including business license taxes at the local level.
• Many factors affect the corporate income tax making it difficult to determine the effect to the state's economy and coffers. For example, nexus interpretations, apportionment and sourcing rules.
• Not all businesses operate in the corporate form. Many businesses operate as sole proprietorships, or some type of passthrough entity (such as a partnership) or as an S corporation. Thus, corporate tax reform does not address the much broader category of business tax reform. Reductions in corporate tax rates may result in lower personal income taxes as other business forms decide to become regular corporations.

I think that a state repeal of its corporate income tax would be attractive to businesses, no doubt. But attractiveness also depends on other taxes it would pay. For example, in California, a business pays sales tax on its equipment and that is easily a 9% increase to the cost of the equipment. Many states exempt equipment purchases by businesses. Infrastructure is also a factor - education, roads, etc. Some local taxes, such as business license taxes may make some local jurisdictions unattractive.

But what about businesses contributing to their use of government services? I think this should be considered. Many of these costs are often local - traffic and police control, such as for a shopping mall. Business license taxes tied to type of industry might help local governments to better handle these types of costs.

It is a complicated analysis and of course, the corporate income tax should not be addressed in isolation of broader state and local reforms. Hopefully states considering reductions in corporate taxes will use that as a stepping stone to looking at the entire tax system and how it can be modernized and made to better meet principles of good tax policy.

The Cost of Tax Administration - IRS FY2012 Budget Request

The IRS budget request was released last week (full text of 166 pages, IRS summary). This is a reminder of the significant costs to collect roughly $2.3 trillion of tax revenues and process over 140 million individual tax returns in addition to millions of other types of returns! The FY2012 budget request is "$13,283.9 million, $1,137.8 million, 9.37 percent, more than the FY 2010 enacted level."

Is 9% budget increase request due to more complicated tax rules to enforce? Will the increase bring in more revenue? How much is due to the IRS being responsible for some part of health care law enforcement?

The $1.1 billion increase includes the following items (per page 3 of the full report):

• +$401.7 million adjustment to reach the FY 2011 President’s policy level
• +$85.7 million to fund the non-pay inflation adjustment and retirement contribution
• -$189.9 million for efficiency savings and non-recur activities
• +$114.3 million to improve taxpayer service and the IRS.gov website
• +$605.7 million to implement legislative mandates, handle new information reporting requirements; increase compliance efforts to address offshore tax evasion, focus on corporate and high-wealth returns, increase examination and collection coverage, enforce tax return preparer compliance, and address workload growth in Appeals and Counsel
• +$118.8 million to enhance employee security, develop disaster recovery systems capability, and develop the information technology, infrastructure, and systems to implement the various Affordable Care Act (ACA) provisions.

Per the IRS, "The FY 2012 budget includes $339 million in new IRS enforcement initiatives, which raise $1.3 billion in revenue annually at full performance. This is a return on investment (ROI) of 4.5 to 1 when new hires reach full potential in FY 2014." A table at page 6 of the full report shows the following expected ROI on various programs when fully implemented in 2014.

• Increased collection coverage 8.8
• Increased international services and enforcement (including 377 new employees) 8.2
• Administering new statutory reporting requirements 7.0
• Implementing merchant and basis reporting (including 415 new employees) 6.0
• Ensure accurate delivery of tax credits 4.1
• Administer new statutory reporting requirements 0.0 (it is puzzling why this items is listed twice. When listed with a zero ROI, the costs are three times higher than the one listed as producing a 7.0 ROI.)
• $96 million of the new enforcement initiatives (less than 1/3 of the total) show zero ROI

A few interesting budget items:

• +$11.5 million / +81 FTE - to implement and enforce the indoor tanning excise tax added by health care legislation
• +$29.3 million / +76FTE to administer new fees on drug manufacturers and health insurers
• +$9.9 million / +84 FTE to strengthen oversight of exempt hospitals
• + $260.3 million / + 834 FTE to ensure accurate delivery of tax credits with a significant amount focused on Affordable Care Act credits
• +$58.5 million / + 187 FTE to administer new statutory reporting requirements including 82 FTE related to new 1099 reporting requirements

A few observations:

• The costs of tax administration are going up. Which makes sense given the increase in the number of tax provisions and activities Congress expects the IRS to be involved with including enforcement of health care provisions.
• Is the expertise of the IRS being used effectively? Why not more on reducing the tax gap and less on enforcing the health care legislation (let a different government agency handle that)?
• It seems that it would be more transparent if Congress allocated enforcement funds whenever it adds new initiatives, such as the expanded 1099 filing requirement rather than requiring the IRS to ask for them separately.

Anything you find surprising?

Continuing EITC Problems Contribute to Tax Gap

On February 9, the Treasury Inspector General for Tax Administration (TIGTA) released a report on EITC compliance problems. Per TIGTA:

"The Internal Revenue Service (IRS) has made little improvement in reducing improper Earned Income Tax Credit (EITC) payments since 2002, when it was first required to report estimates of these payments to Congress, ... The IRS estimates that 23 to 28 percent of EITC payments are issued improperly each year, which equated to $11 billion to $13 billion in EITC improper payments in Fiscal Year (FY) 2009."

TIGTA's recommendations mostly sound to me like "try harder." I think part of the problem is due to complexity (the EITC eligibility and calculation are some of the more difficult provisions in the law). Some of it may also be due to the EITC built-in incentive to try to claim a high credit, including increasing your taxable income to generate the largest credit amount. For an example of some of the EITC complexity, take a look at this IRS website on the EITC - it seems a bit daunting to me.

Why no better solution? Is the EITC just fundamentally flawed as a way to deliver benefits to low-income workers? Well, it does work for the majority of filers, but a 25% error rate is too high.

Back in 2001, I had an EITC proposal included in the Joint Committee on Taxation's simplification study for Congress (here - summary of page 7 and full text on page 205). It called for a mechanism to get the benefit to workers through reduced or zero Social Security withholding. Part of the concept would have been similar to the Advanced EITC which was repealed recently. I also noted that if we ever went to a return-free system for a majority of individuals, EITC reform would be helpful.

What do you think would reduce the tax gap resulting from EITC errors?

Cell Phone Tax Issues

Last October I posted about the oddity of H.R. 1521 introduced to limit state and local taxes on cell phones so the industry could grow when the Pew Center reported that over 80% of individuals have cell phones (10/20/10 post). I came across more oddities today. The Tax Foundation just released a report - Fiscal Facts - States Target Cell Phones for Stealth, Burdensome Taxes by Joseph Henchmen. The report shows the average tax rate per state. California's is 10.67%. It also points out a few weaknesses of such taxes particularly the lack of transparency. Although the taxes are shown on cell phone bills, many people do not look at them or can't tell how they are computed.

The article also refers to a Forbes article - Scott Wooley, "How to Duck Cell Phone Taxes" (6/6/05) that describes how the Mobile Telecommunications Sourcing Act (PL 106-252; July 28, 2000) was (at least when the article was written in 2005) being interpreted differently by cell phone providers. That Act basically requires the cell provider to charge taxes based on the customer's place of primary use. That likely is the customer's billing address. But as the Forbes article pointed out, some providers determined the primary place was tied to the customer's area code. Also, the writer of the article states that he changed his address and phone number to Idaho, which he visits regularly, signed up for electronic billing and gets to use his phone mostly in Los Angeles but pay the lower Idaho cell phone rate. Clearly, something is wrong with the Mobile Source Computing Act and how it is interpreted. Part of that might just be that taxing cell phones is out-dated.

Ideally, the tax should go to the jurisdiction where it is used, but that can be difficult to compute. But, it is also easy to change ones area code (get a new number) or address. Given cell phone billing practices, I think many people do not bother to get a different phone number when they move. I know that more and more, I find that one's area code does not tie to where they live. And, as more people get paperless billing, their address is really not important (unless it is for a utility tied to their home, such as the gas or electric). So, perhaps this phone tax really just doesn't work any more.

BUT - in California, several cities collect the tax as part of their utility user tax system. Given challenges of replacing the tax with something else, namely, getting voters to approve the new tax, it is difficult for cities to modernize their tax systems.

This is an interesting issue. I plan to look more closely into how the Mobile Sourcing Act is interpreted and if there has been any rulings on that issue.

What do you think?

Virtual Tax Dollars

This is post is partly light-hearted, but also notes an area in need of guidance. I saw a Bloomberg News item in the Mercury News today (2/15/11, pg D3) on game-maker Zynga. It notes that people can play their Facebook games for free but the company makes money from people buying "virtual goods." That means people are spending real money buying pretend goods, supporting a viable company.

I think governments have missed opportunities here. Why don't they create web games where people can buy virtual items - a tax return showing you are a multi-millionaire? A private island? Pay your virtual accountant to prepare your return? Pay someone to set you up in a tax shelter? Perhaps the government could lower the deficit this way.

Well, it also reminds me that in 2006, the Joint Economic Committee issued a press release (10/17/06) saying that they were studying tax issues of virtual money and would issue a study. But it was never issued.

In 2008, the National Taxpayer Advocate's annual report to Congress included a section on the need for the IRS to issue guidance on virtual worlds. The report noted a "“serious problem” and that “the IRS should proactively address emerging issues such as those arising from “virtual worlds.”” (2008 Report, page 213-226) No guidance has been issued.

There are not only perhaps some money-making opportunities for the government with virtual items, but the need to update the tax law guidance to be sure people know possible tax consequences of playing virtual games, having virtual money, and more.

Twitter and San Francisco proposed tax break

An item on the February 8, 2011 San Francisco Board of Supervisors agenda was the following:

"110155 [Business and Tax Regulations Code - Payroll Expense Tax Exclusion in Central
Market Street and Tenderloin Area]
Sponsors: Mayor; Kim, Chiu and Farrell
Ordinance amending Article 12-A of the Business and Tax Regulations Code by adding Section
906.3 to establish a payroll expense tax exclusion for businesses located in the Central Market
Street and Tenderloin Area. ASSIGNED UNDER 30 DAY RULE to Budget and Finance
Committee."

As reported in the press,* this amendment is to provide a 6 year payroll expense tax holiday for companies hiring new employees in the area noted above, most notably, for Twitter which is considering moving out of San Francisco.

* For example, see San Francisco Chronicle, 2/10/11 - "Tax break to Twitter makes sense."

Additional Information:

• Per the Twitter website - they have job openings - quite few are listed!
• The SF Payroll Tax Expense is described by the city as follows: "all businesses with a taxable San Francisco payroll expense of greater than $150,000 must file a Payroll Expense Tax Statement for their business annually by the last day of February for the prior calendar year (Jan. 1st - Dec. 31st). The Payroll Expense tax rate is 1.5% or .015. You calculate the Payroll Expense Tax by multiplying the business' annual San Francisco payroll expense by 1.5% or .015, the Payroll Expense Tax rate." So, this tax is on medium and large-size businesses.

Tax Policy Analysis:

• Equity: The proposal is not just aimed at Twitter but at any company that adds employees in the designated area. This makes the tax cut more equitable.
• Neutrality: The proposal violates the principle of neutrality in that it will encourage companies to locate new employment in the designated area rather than in other parts of the city.
• Accountability: Stories in the papers noted that Twitter's employee base would be growing from 200 to 2,000 over the next few years. But what if it doesn't grow that much? Of course if it doesn't grow that much, it would never owe payroll tax on a higher payroll expense amount because there wouldn't be higher payroll. But while it will likely grow past 200 employees, what if it doesn't meet some particular goal? The city would have lost the payroll tax on the greater number of employees without the benefit of having offered the tax break in the first place. For accountability, a goal and clawback provision should be included. For example, if an employer's employment doesn't grow by X% by a certain date, it must pay back some percentage of the tax savings it obtained.
• Appropriate government revenues: Does the city not need more tax revenues? It is likely considering the fact that without Twitter, it will have nothing, so keeping it and collecting payroll tax on 200 employees is better than nothing. But will the city be able to deliver services to a larger company without additional revenues? Will other tax increases or spending cuts be needed?

Tax incentives tied to competitive pressures facing jurisdictions can be difficult. Whatever city Twitter is planning to move to (I saw two different cities noted in newspaper articles), could offer some better tax break. This is what economists call the "race to the bottom" with the companies being the winners and the jurisdictions and other taxpayers often the losers.

What do you think?

Wanting to Pay More Taxes and Charitable Contribution Issues

The other day, a few of my graduate tax students asked why Congress had enacted a Social Security tax cut for 2011 for all employees and self-employed rather than keeping the money for deficit reduction. That is a good question. If Congress wanted to provide some benefits to low-income taxpayers, they could have reinstated the Making Work Pay Credit which reached fewer individuals and was a smaller tax cut. So, Congress seems to be sending a message to the public - "Deficit? What deficit?"

An article in today's Wall Street Journal tells the story of some parents in Kansas that want to pay more property taxes to better fund their schools ("Tax Compliant: Too Low"). But, there is a limit on school funding so the state says they can't pay more property taxes. The purpose ties to equity and keeping more uniform funding among all schools.

These are interesting stories - some people want to pay more taxes! Solutions:

1. Write a check to the government.
2. Write your elected officials to let them know you want to pay more taxes.
3. For the school issue - make a charitable contribution to the school.

The last option will get most taxpayers and the school to the same situation. For individuals who itemize their deductions, both the charitable contribution and property taxes are deductible. So, what is the property tax and equity limitation yielding if parents just donate what they would otherwise like to pay in taxes? This is an oddity in the law for many reasons, such as:

• Whether paid as property tax or a charitable contribution, itemizers get the same tax treatment (unless they are subject to a charitable contribution limit due to donating over 50% of their income; but that is likely not the case for most of the parents).
• The federal and state governments are subsidizing the payments. That is, when the payor takes the tax deduction, they save on their taxes. The higher their tax bracket, the greater the savings (and the share of the contribution really paid by the government). For example, if the parent has a federal marginal tax bracket of 25% and donates $1,000, they save $250 of taxes (if their tax bracket is 35%, they save $350!). It is as if the federal government made a payment to the school of $250. Yes, that means that large donations by high bracket individuals to what might already be well-funded schools, results in a federal government subsidy to the school that likely doesn't warrant it under any government program other than the tax law! The charitable contribution deduction is available even if your child is one of the beneficiaries of your donation.

So, I think the story points to two problems in the law:

1. It is not obvious or easy for people to pay extra taxes of their own volition.
2. Tax deductible payments include government subsidies. These don't show up in the school budgets though. The deductions enable the donors to donate greater amounts - the higher the bracket, the greater the donation ability and the greater the government subsidy.

Solutions include:

• Converting the charitable contribution deduction to a tax credit that is the same value for all taxpayers.
• Limiting the deduction when you donate to your child's school due to the reality that your child is a beneficiary. When you pay tuition at the private school your child attends, you get no tax deduction because your child is a beneficiary. Is it that different when you donate to your child's school? And, I have heard from some parents that at the start of the school year, the PTA or Home & School Club calls the parents and requests a donation with the amount based on how many children you have at the school - is that really a charitable contribution or a direct benefit for your child?
• Stopping the assumption that everyone wants a tax cut. Some people want to reduce the deficit!

What do you think?

Tax Expenditures and Income Tax Reform

There has been greater talk, including some op eds, on the need to reign in "tax expenditures" - tax rules that are not necessarily in the law to measure income, but to provide some type of subsidy or incentive, such as energy credits, or the mortgage interest deduction. The National Taxpayer Advocate's 2010 report notes that the roughly $1 trillion of tax expenditure means that everyone pays higher rates to help pay for this cost.

But, tax expenditure numbers should be approached carefully to know what the numbers mean and don't mean. I have a short article published today in the AICPA Tax Insider - Rethinking the Income Tax Calculation. It explains what a tax expenditure is and some of the cautions to exercise wen using this data.

Do you think Congress will start to reduce the number of tax expenditures as part of income tax reform?

Unemployment Tax

There is a good article in the Wall Street Journal today about President Obama's likely budget proposal to increase the base upon which unemployment tax (FUTA) is owed by employers. The article also includes a Q&A on how employment taxes work by Sara Murray - here.

A few observations:

• One element of tax policy (tax system design) is who pays the tax - directly and indirectly. The FUTA is imposed on employers, but most likely really paid by employees in the form of lower wages and partly by customers in higher prices.
• Unemployment covers employees. Should there also be a safety net for self-employed individuals who either lose their entire business or see a reduction during an economic downturn? Why not have all workers and service recipients (employers) pay some portion of compensation into a fund that workers could draw upon for emergency living expenses or retraining?
• There are some compliance and tax gap issues with unemployment taxes. One problem is referred to as SUTA dumping where a business might set up a new business in order to get a lower unemployment tax rate. For more on that, see information on the California EDD page - here.

What do you think? Should the employer payments be increased? Are there better approaches to helping unemployed and underemployed employees and self-employed individuals?

Public Understanding of the Tax Structure

As he promised when he campaigned, Governor Brown should be calling for a vote before the end of June 2011 so the public can weigh in whether there should be a tax increase. In California, the temporary .25% increase in rates expired at the end of 2010 and the sales tax increase expires mid-2011. Continuing these is unlikely to be sufficient to balance the budget so there will be spending cuts and perhaps a look for other revenue sources, such as a oil severance tax. Governor Brown has also mentioned eliminating enterprise zone tax provisions and redevelopment agencies.

California's tax system is quite complicated. Can the public adequately determine whether taxes should be increased and if so, how? As I like to note - California's tax problems can't be solved with rate increases, the problems are in the base (see here). I like Dan Walters' op ed in the San Jose Mercury News on Thursday February 3 - "Public's tax ignorance a big hurdle for Brown." He offers a few examples of the low understanding of the fiscal picture. For example, a survey by the Public Policy Institute of California found that while most voters believe they have substantial knowledge of state and local government finances, only 16% knew that K-12 was the largest state expenditure.

How can one single person truly understand the amazing intricacies of California's fiscal system? Most people likely just view it as paying income, sales and property taxes. How many know they also pay a variety of excise taxes and vehicle taxes? How much of the corporate tax is passed through to them? Where do their property tax dollars go? How much of the sales tax goes to the local jurisdictions? How many know that there are 471 cities, 58 counties and over 3,000 special districts? How many people can trace tax dollars after the subventions, triple flips and backfills are taken care of? What is ERAF?

Michael Coleman, expert on local finances, with lots of information on his website to explain the odd route tax dollars flow to get to their ultimate use and the effect of the many propositions and laws that created this maze. Take a look at his presentation from January 2011 with Paul Navazio, Assistant City Manager, City of Davis - Financial Management 101: Financial Management and City Revenues.

So, what should the voters be asked? What public awareness campaigns should take place before then to give voters some chance of understanding the fiscal structures in California as well as principles of good tax policy so they can figure out where problem areas are?

What do you think?

California has highest sales tax rate

On February 3, 2011, the Tax Foundation released a Fiscal Fact report -
Ranking State and Local Sales Taxes by Kail Padgitt (html) (pdf). The data reported for January 1, 2011 shows that California has the highest state tax (but they include the 1% that goes to local jurisdictions) and combining the state and local rates, California has the second highest rate (average 9.01%) just after Tennessee at 9.44%). Colorado has the lowest state rate at 2.9% (quite a difference from California!) and seven states have a 4% rate including New York.

In Santa Clara County, the sales tax rate is 9.25% - that's high. Some might argue that it is high because the state needs money. Yes, the state has lots of expenses, but it also has a very narrow sales tax base with respect to how it applies to personal consumption. California exempts food (other than at restaurants), utilities, digital goods, personal services and live entertainment. That represents a lot of personal consumption. Broadening the base and lowering the rate would make the tax more equitable and simpler (fewer exemptions to define). It could also generate funds to reduce the pyramiding in the sales tax, such as by allowing or phasing-in, an exemption for manufacturing, R&D and other equipment which could help make the state more attractive for businesses.

I've written about this before - and presented testimony on the topic ...

• Testimony before CA Assembly Revenue & Taxation Committee on 1/13/2010 for informational hearing on alternatives to the COTCE recommendations (pdf).
• Papers, op eds and older testimony

What do you think would improve California's sales tax?